Bear-Market Rally Autopsy

Before it gasped its final breath in May 2002, the only television series I really
enjoyed was Chris Carter's outstanding "The X-Files".

The excellent series chronicled the strange journeys into the unexplained
by a pair of FBI agents who were called in when crimes and crime scenes defied
all attempts at conventional explanations. Each week agents Fox Mulder and
Dana Scully explored some new surreal and bizarre crime scene or delved deeper
into a fantastically complex web of government conspiracies and paranoia.

Agent Scully was the rational scientific type of the excellent chemistry-filled
pairing. As both an FBI special agent and a medical doctor her extensive training
led her to always seek rational logical answers as a counterbalance to her
partner agent Mulder's quick embrace of the paranormal or forces unknown to
explain a crime.

When Mulder and Scully began investigating a new mystery each week, one of
the staple X-Files scenes involved Dr. Scully performing an autopsy on the
victim. These autopsies were always a special treat for viewers because without
fail something really weird and totally unexplainable would turn up which would
advance the plotline of that particular episode and sometimes the entire series.

The X-Files autopsies were masterfully used to create suspense, advance the
storyline, and to let the viewer in on some special knowledge which would prove
critical. Much was learned in these signature autopsy scenes that proved very
beneficial later on in the hour.

This week as my partners and I were discussing the recent powerful bear-market
rally in US equities, I found myself pondering the X-Files autopsies. Like
most other investors and speculators, we seek insight and wisdom into future
market movements by throwing the naked past up onto a cold, stainless-steel
autopsy table and dispassionately dissecting it.

Sometimes a post-mortem autopsy of the market past yields excellent insights
and sometimes it unfortunately merely leaves a bloody mess on the autopsy table.
Yet this very Great Bear against which
we are all valiantly battling these days has allowed three massive bear-market
rallies in the past two years, so perhaps its modus operandi in the past can
provide clues on what to expect in the future.

Is our current bear-market rally in US equities finally giving up its ghost?
Or does it still have farther to run?

As I mentioned last week, some outstanding technical indicators like the Put/Call
Ratio indicate this bear-market rally is probably already over and others
like the venerable VIX suggest it may
yet still have some life left in it. With these two powerful indicators not
singing in perfect harmony on the near-future market direction as traders
prefer to see, perhaps an autopsy of the three massive bear-market rallies
since early 2001 can yield some more clues.

While thankfully we have already been blessed with some excellent early unrealized
profits in our latest stock-index speculations outlined in the new December
issue of Zeal Intelligence, much uncertainty
remains over the immediate fate of our current bear-market rally. As always
the more uncertainty that investors and speculators can dispel, the better
the information will be on which they base their decisions. The better the
information, the higher the probability of achieving wildly profitable trades!

So, in the spirit of Dr. Dana Scully's fearless X-Files' autopsies we are
shifting gears a bit this week and dissecting the carcasses of the last three
massive NASDAQ bear-market rallies themselves. Rather than relying solely on
the exogenous technical indicators like the VIX and PCR 21dma that we usually
pay homage to, perhaps valuable clues lie within the steaming entrails of the
deceased bear rallies themselves.

The three massive bear rallies we dragged up onto the stainless-steel autopsy
table were born on April 4th, 2001, September 21st, 2001, and October 9th,
2002. While we did have to zoom in and execute these dissections under a tactical
magnifying glass as the graphs below show, these major bear rallies are also
quite evident from a strategic perspective.

We updated our large NASDAQ 2000 vs. DJIA 1929 bubble-comparison graph this
week and the latest iteration is available at http://www.zealllc.com/2002/1929.htm if
you are interested in checking it out. Each of the three enormous bear-market
rallies dissected below stick out like an elephant trying to hide under your
living-room rug even when viewed from altitude far above the muddy market battlefields.

The methodology for our bear-market rally autopsies this week is simple. We
wanted to see if there are any signature price patterns or decay that is common
among all three episodes that could potentially mark the end of the bear-market
rally in which we currently sojourn. In order to compare the rallies, we measured
each major pullback in each rally within its entire lifecycle. Perhaps a common
thread would emerge that grants us some valuable clues on the Great Bear's
modus operandi.

You probably remember the first of our specimens, a super-impressive monster
of a bear rally that erupted in early April 2001. Shortly after, Alan Greenspan
launched a frantic surprise inter-meeting 50bp rate cut and Wall Street
perma-bulls zealously declared that the bear market was finally over.

Then, ensuring that I wouldn't get invited to any Wall Street Christmas parties
in 2001, I wrote a controversial essay published May 11th, 2001 called "Equity
Bulls in Denial" with the audacity to brazenly claim that "the
bear market in the US is just beginning, NOT ending as most bulls and bullish-bears
assert today. This current NASDAQ, DJIA, and S&P action looks and smells
like a bear market rally, as there is no fundamental foundation for the spectacular
gains since early April."

As far as bear-market rallies go, this was certainly an impressive specimen.
It rocketed up slightly over 41% in only 33 trading days on a closing basis.
Using intraday numbers, the daily highs and lows that are marked above with
the red and green lines, the rally soared almost 44% trough to peak. It was
no doubt an exciting few months of market action!

The distinctively spiny shape carved in the graph above just begs to be dissected
and analyzed. In this autopsy, we are focusing on the pullbacks, normal ultra-short-term
bearish episodes punctuating the bear-market rally itself. Next to each pullback,
bound by the yellow arrowheads, the actual percentage of the pullback on a
closing basis is marked. The evolution of the magnitude of these pullbacks
is quite interesting.

Early on in a bear rally, folks are just relieved that the bottom didn't fall
out on the preceding bounce and they buy with reckless abandon. With popular
greed rampant, temporary sell-offs tend to be quite small and they are soon
offset with heavy buying which once again propels the bear-market rally on
to dazzling new heights. Note above how the first pullback approached only
4% and the second not even 3%, quite modest for the hyper-volatile NASDAQ casino.

Yet, later in a bear rally, after the markets have run up 20%, 30%, even 40%
in a matter of weeks, investors and speculators begin to grow nervous. They
start expecting a major pullback and begin to fear that the end of the bear-market
rally draws nigh. This fearful psychology leads to more selling with each pullback
as speculators want to ensure that they have harvested at least some of their
profits before the bear rally fails.

At this late stage in the evolution of a normal bear-market rally, the pullbacks
grow much larger. Note above how the early small pullbacks gave way to a pullback
approaching 8% and then another slightly over 6%. The pullbacks, initially
small in the bear rally, generally begin to grow as the rally matures and popular
greed fades.

Then, seemingly out of the blue the bear-market rally suddenly reaches its
interim top almost as mystically and without fanfare as when it had earlier
emerged out of the mists of popular despair when it was born. Following the
top, each pullback seems to grow in magnitude, becoming more powerful and difficult
to overcome for the remaining bulls. As the rally above topped, the next two
pullbacks weighed in at about 10% and 12%, four times as large as the early-stage
pullbacks!

Like a car fishtailing on ice, the bear-rally pullbacks began as small oscillations
when the bulls were in full control early on, but as they lost more and more
control the pullbacks grew larger and larger. When a rear-wheel-drive car starts
fishtailing on an icy winter road, its initial lateral movements are small,
but the driver overcorrects, and each subsequent fishtailing slide is larger
and larger until control is totally lost and the car crashes, or the bear rally
collapses.

In this first bear rally autopsied above, it is provocative that these bear-rally
pullbacks start small initially, soon grow larger, and finally get huge as
the bear rally inevitably fails. Is this distinct signature also seen in the
other two massive NASDAQ bear-market rallies we have witnessed in recent years?

Let's roll this first bear-rally carcass and its guts off our stainless-steel
autopsy table and make room for our second dearly-departed bear-market rally.
It surged to life following the infamous events of September 2001. While the
bear rally was due anyway before the Towers fell, the attacks had the psychological
effect of forcing the markets even lower before they bounced and the misplaced
financial-market patriotism pushed the following bear rally even higher than
it would have probably normally run.

As the bear rally was born popular greed soared and Wall Street once again
emphatically declared that the bear was finally dead and a glorious new bull
market in equities had been miraculously reborn from the ashes of 9/11 like
a phoenix.

Ever the belligerent contrarian, once again I did my best to call a spade
a spade and warn people that this too was merely a bear-market rally that would
soon collapse. In "Bear
Market Rallies" published on November 23rd, 2001 I said, infuriating
the perma-bulls yet again, "the odds are vastly in favor of the bearish
thesis that the current US equity rallies are little more than seductive bear
market rallies that will ultimately collapse to new lows." Sheesh, you
can't take me anywhere!

This bear-market rally augmented by the horribly shameful and morally degenerate
Wall Street repackaging of national patriotism and sorrow with the buying of
overvalued US equities was simply enormous. Its trophy-grade carcass barely
fits on our dissection table for autopsy with a whopping trough-to-peak gain
of almost 45% on a closing basis. From its intraday trough to its intraday
peak, this magnificent bear rally rocketed up by an unfathomable 51%+! Bear
rallies in major equity indices don't get much bigger than this fellow.

Since this specimen ran so high and lasted so long compared to a typical bear-market
rally, there are more major pullbacks for us to examine. The dissection of
these pullbacks is also quite interesting, especially in light of our post-mortem
observations of bear-market rally numero uno discussed above.

As you can see in the graph, the first few pullbacks right after this bear
rally's birth were small, running about 3%, 2%, and 4%, right in line with
what we observed above. Extreme greed and relief ruled the roost and early
selling was quickly met with massive buy orders from speculators trying to
buy the dips just as Wall Street evangelists preach for them to do.

Then, just as in the first specimen, as this bear rally reached middle age
and its last legs, its pullbacks generally grew. It witnessed pullbacks of
about 6%, 3%, and 7%. The 3% is quite small, but the 6% and 7% bracketing it
were notable pullbacks. Deploying the fishtailing car analogy once again, as
the bear-market rally aged its mini-bearish internal oscillations grew more
and more severe.

Finally, just as above, the terminal pullbacks immediately after the top weighed
in at about 9%, 8%, and 8%, big numbers. As soon as the 8%+ pullback level
was reached, the bear rally was over as bearish forces had finally overcome
the immense bullish inertia that initially fueled the bear-market rally. Early
pullbacks of low single-digit percentages gave way to later pullbacks of mid
single-digit percentages. Ultimately the bear rally gave up its ghost on high
single-digit percentage pullbacks just like its ancestor immediately before
it.

On a sidenote, there is one other interesting observation to ponder in the
bearish entrails sliced open above. The final bear-rally top on a closing basis,
the one right before the 8.6% pullback, occurred a few days before the ultimate
intraday top. You can see the final intraday top as a spike in the light red
intraday-high line above to 2100. This development may appear trivial, but
as any X-Files fan knows sometimes the slightest observations can break a case
wide open.

Perhaps the final intraday spike above marked the last gasping breath of the
bulls. They launched a valiant assault on new highs to try to keep the bear
rally alive but it was repelled by deeply entrenched bearish defenders and
the NASDAQ didn't close anywhere near its high that day. This big negative
divergence may be a post-mortem fingerprint of the hard-to-detect psychological
turning point when the majority of speculators have finally switched from greed
to fear mode.

Well, with two bear-rally autopsies completed we can now focus our attention
on today's impressive bear-rally specimen which burst onto the scene in October
2002. It is not quite as beefy as its ancestors, but it still yielded immense
profits for those courageous enough or foolish enough to throw countertrend
long for a couple months or so in the midst of a brutal supercycle bear-market
bust.

Lest you fear that I am some Johnny-come-lately to this bear-rally party like
most of the talking heads on television, please consider my comments in the "Trading
Volatility Ratios" essay published on October 4th, 2002, a few days
before our current specimen was born. Earning the undying wrath of the perma-bears
I dared to utter these blasphemous words, "If the SPX/VIX ratio proves
true to its golden historical track-record, we are in for a spectacular bear
market rally that will knock the socks off those not expecting it and yield
legendary profits for those who are." Now the bears won't invite me to
their Christmas parties either! Sigh.

Look familiar? We have all just traveled down this intriguing road. This particular
massive bear-market rally was up a respectable 34%ish in closing terms or about
37% from its intraday trough to peak. But is it over yet? The PCR
21dma is sure signaling the death knell of this bear rally as discussed
last week, but the VIX still steadfastly
suggests it can run higher from here. Can our autopsy break this deadlock in
the warring elite technical indicators?

Not surprisingly the modus operandi of the Great Bear this time around is
the same as during the last two massive bear-market rallies in the NASDAQ.

Early in this bear-market rally we witnessed the requisite small pullbacks,
4% and 2% this time around. Then as this bear rally matured a 7% pullback was
registered as the magnitude of the mini-bearish oscillations flying in the
face of the short-term bullish tide increased. A subsequent smaller 3%ish pullback
then ensued, similar to what we observed as we peeled back the flesh in specimen
numero dos discussed above.

Déjà vu eh? The Great Bear is kindly standing aside to let the bulls
frolic this time just as it has the last two times before it roared out of
the shadows like a juggernaut and slaughtered the terrified bulls with one
mighty claw-studded swipe. The comparisons among the three massive bear rallies'
internals are quite provocative and ominous.

The killer X-Files-like suspense really soars when looking at the latest December
pullback though. It has shed a little over 8% peak to trough thus far. If you
scroll back up and examine the previous two graphs, you will note that none
of the previous bear-market rallies has ever recovered from an 8%+ pullback!
Under 8% seems manageable for some reason, the bulls can overcome a sub-8%
pullback to corral the bear-market rally even higher. But any pullback over
8% has so far proven to be an insurmountable hurdle for the stampeding bulls
to overcome.

In addition to the dark tidings of this fresh 8%+ pullback, you will also
notice a large intraday NASDAQ spike a couple days after the closing interim
top to date marked by the red line above. As you remember from our second specimen's
autopsy, this final last gasp by the charging bulls seemed to mark a subtle
turning point in general psychology. From this moment forward last time around
the bears once again gained the upper hand over the bulls in short-term-speculation
land!

An 8%+ pullback coupled with a delayed failed intraday attempt to extend the
life of this particular bear rally offer more evidence that this bear-market
rally already has one foot in the grave. While it certainly could still run
higher, the PCR sell signal discussed last week coupled with these decidedly
bearish technical internals suggest the scales of probability are now drastically
tilted towards the short side in the coming months.

Dr. Scully would have been proud of our cursory bear-market rally autopsy!

Speculators may wish to prepare accordingly by deploying potentially immensely
profitable short-side-oriented trades as we discussed for our subscribers in Zeal
Intelligence this month. Investors may wish to consider moving capital
out of the overvalued US equities into cash or gold and silver stocks to ride
out the coming brutal general stock-index downleg.

Take cover, as the bears are once again regaining the balance of short-term
power.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to
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